Many business entities raise money by means of a mix of debt instruments, such as bonds, and equity instruments, such as stock. The mix selected by a particular entity is influenced by prevailing interest rates, as well as other factors such as the extent to which the market is willing to purchase newly issued instruments of one type or the other at any particular time. Convertible instruments have some of the qualities of bonds as well as some of the qualities of stock. A convertible instrument, such as a convertible bond, is a debt instrument which can be converted by its holder into a number of shares of stock, the number typically being fixed or being determined by a formula. Often, such an instrument states a conversion price per share. With such an instrument, the conversion price is divided into the par value of the bond to determine the number of shares available in the conversion. Thus, a holder has the option of converting the bond into shares of stock, as opposed to simply cashing in the bond in order to retire the debt obligation of the issuer.
One disadvantage of issuing convertible bonds is that such instruments may have an adverse affect on a company's apparent diluted earnings per share (EPS) figure. Under generally accepted accounting principles, it is typically assumed that convertible bonds must be accounted for using the “if converted” method of accounting in determining a company's EPS. Thus, all shares into which outstanding bonds could potentially be converted must be considered outstanding shares for purposes of calculating the EPS.
As an example, consider a two hundred million dollar convertible bond offering which in the aggregate, is convertible into four million shares and pays interest at a rate of four percent annually. Assume the conversion price of the bonds is fifty dollars per share. Further, assume that the issuer has one hundred million actual diluted shares outstanding, and a net income of three hundred million dollars not considering the bond offering. Using the “if converted” method to calculate the diluted EPS for the issuer, the full conversion of all the bonds without regard to share price would be assumed. Under this method, the shares underlying the convertible would be added to shares outstanding (the diluted EPS denominator). In addition, net income would be reported without reduction by the interest expense associated with the convertible bonds (the diluted EPS numerator). The resulting EPS computation would be compared to basic EPS, which is computed using net income reduced by the bond interest expense (the basic EPS numerator) and the shares outstanding excluding the shares underlying the convertible (the basic EPS denominator). The more dilutive of these computations would be utilized for diluted EPS reporting purposes. For most issuers, the inclusion of the shares in the EPS denominator produces a more dilutive result than basic EPS. For those issuers, the diluted EPS would be calculated as follows:
                                          net            ⁢                                                  ⁢            income                                                            (                          without              ⁢                                                                                ⁢                                                                              ⁢              reduction              ⁢                                                                                ⁢                                                                              ⁢              by              ⁢                                                          ⁢              bond              ⁢                                                                                ⁢                                                                              ⁢              interest              ⁢                                                          ⁢              expense                        )                                                                                  diluted              ⁢                                                          ⁢              shares              ⁢                                                          ⁢              outstanding                        +                                                            shares            ⁢                                                  ⁢            underlying            ⁢                                                                      ⁢                                                                    ⁢            bonds                                =      diluted    ⁢                  ⁢    EPS  or, in this example:$300/(100+4)=$2.88 diluted EPS
Note that without including the shares underlying the convertible bonds, the diluted EPS number typically would be higher since the denominator of the above equation would be smaller. Although the numerator would be smaller as well, the denominator effect dominates the calculation for most issuers. Consequently, the adverse effect of the if converted method of accounting on diluted EPS can serve as a deterrent to issuing convertible instruments.